Chapter 1
Introduction to Financial
Management
 Forms of Business Organization
 Stock Prices and Shareholder Value
 Intrinsic Values, Stock Prices, and


Executive Compensation
Important Business Trends
Conflicts Between Managers,
Stockholders, and Bondholders
1-1
Finance Within the Organization
Board of Directors
Chief Executive Officer (CEO)
Chief Operating Officer (COO)
Chief Financial Officer (CFO)
Marketing, Production, Human
Resources, and Other Operating
Departments
Accounting, Treasury, Credit,
Legal, Capital Budgeting, and
Investor Relations
1-2
Proprietorships and Partnerships

Advantages

Disadvantages
 Ease of formation
 Subject to few regulations
 No corporate income taxes
 Difficult to raise capital
 Unlimited liability
 Limited life
1-3
Corporation

Advantages

Disadvantages
 Unlimited life
 Easy transfer of ownership
 Limited liability
 Ease of raising capital
 Double taxation
 Cost of set-up and report filing
1-4
Income Statement ISM, Tbk
5
Income Statement ISM, Tbk
6
Determinants of Intrinsic Values and
Stock Prices
Managerial Actions, the Economic
Environment, Taxes, and the Political Climate
“True” Investor
Returns
“True”
Risk
“Perceived”
Investor Returns
Stock’s
Intrinsic Value
“Perceived”
Risk
Stock’s
Market Price
Market Equilibrium:
Intrinsic Value = Stock Price
1-7
Corporate Valuation
8
Sales revenues
−
Operating costs and taxes
−
Required investments in operating capital
Free cash flow
(FCF)
Value =
FCF1
+
(1 + WACC)1
FCF2
+
(1 + WACC)2
=
+ ...
FCF∞
(1 + WACC)∞
Weighted average
cost of capital
(WACC)
Market interest rates
Cost of debt
Firm’s debt/equity mix
Market risk aversion
Cost of equity
Firm’s business risk
Stock Prices and Shareholder Value

The primary financial goal of management is
shareholder wealth maximization, which
translates to maximizing stock price.
 Value of any asset is present value of cash flow
stream to owners.
 Most significant decisions are evaluated in terms
of their financial consequences.
 Stock prices change over time as conditions
change and as investors obtain new information
about a company’s prospects.
1-9
Stock Prices and Intrinsic Value




In equilibrium, a stock’s price should equal its
“true” or intrinsic value.
Intrinsic value is a long-run concept.
To the extent that investor perceptions are
incorrect, a stock’s price in the short run may
deviate from its intrinsic value.
Ideally, managers should avoid actions that
reduce intrinsic value, even if those decisions
increase the stock price in the short run.
1-10
Some Important Business Trends



Recent corporate scandals have reinforced
the importance of business ethics, and have
spurred additional regulations and corporate
oversight.
Increased globalization of business.
The effects of ever-improving information
technology have had a profound effect on all
aspects of business finance.
1-11
Conflicts Between Managers and
Stockholders


Managers are naturally inclined to act in their
own best interests (which are not always the
same as the interest of stockholders).
But the following factors affect managerial
behavior:
 Managerial compensation packages
 Direct intervention by shareholders
 The threat of firing
 The threat of takeover
1-12
Conflicts Between Stockholders and
Bondholders



Stockholders are more likely to prefer riskier
projects, because they receive more of the
upside if the project succeeds. By contrast,
bondholders receiving fixed payments are
more interested in limiting risk.
Bondholders are particularly concerned about
the use of additional debt.
Bondholders attempt to protect themselves
by including covenants in bond agreements
that limit the use of additional debt and
constrain managers’ actions.
1-13